Legal capital definition
/What is Legal Capital?
Legal capital is that amount of a company's equity that cannot legally be allowed to leave the business; it cannot be distributed through a dividend or any other means. It is the par value of common stock and the stated value of the preferred stock that a business has sold or otherwise issued to investors. The legal capital concept does not apply to any stock that is authorized for issuance but which has not yet been issued.
The original intent of legal capital was to create a reserve that could be accessed by a company's creditors in the event of default. However, the concept is effectively negated for those businesses issuing stock having extremely low par values. For example, if a company issues a share of common stock at a par value of $0.01 per share (an extremely common par value), this means that only $0.01 of the amount for which the share is sold must be reserved as legal capital, while all other receipts are credited to the additional paid-in capital account. Thus, even an issuance of 1 million shares would only yield legal capital of $10,000, assuming a par value per share of $0.01. In this example, the company issuing the 1 million shares could issue a dividend to its investors in the amount of the additional paid-in capital associated with the sale, but could not issue a dividend for the $10,000 designated as the par value (i.e., legal capital) of the stock.
Is Legal Capital Mandatory?
The requirements for legal capital are set by state law; there is no federal requirement for it. Some states do not require any par value, which means that companies incorporating in those states have no legal capital requirement at all. The general trend is away from legal capital, since it has become such a tiny proportion of a corporation’s capital base that it delivers essentially no protection to a firm’s creditors.
Example of Legal Capital
Toad Corporation issues 100,000 shares of common stock with a par value of $1 per share, and it sells these shares to investors at $10 each, raising $1,000,000 in total. The legal capital in this case is $100,000, which is calculated as 100,000 shares × $1 par value. This $100,000 is the amount that must remain in the company and cannot be distributed as dividends or returned to shareholders through stock repurchases. The remaining $900,000 (the amount received over par) is considered additional paid-in capital and, while also equity, it is not subject to the same legal restrictions as the par value. If the company also issues 10,000 shares of preferred stock with a stated value of $5 per share, the legal capital increases by another $50,000 (10,000 × $5), bringing total legal capital to $150,000.
This example illustrates how legal capital is strictly tied to the par or stated value of issued shares, not the market price or amount received, ensuring that a portion of equity remains in the business for creditor protection.
Terms Similar to Legal Capital
Legal capital is also known as stated capital.